This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the top of any article.

Gold AHA Winner in Financial Risk Management

Hedging Against an Economic Upturn: Google

Many risk managers try to prepare for things going wrong. Google tackled the problem of protecting itself if things go right—if the global economy turns around and interest rates head higher. The company had invested in agency mortgage-backed securities (MBS) because of the relatively attractive yields (1.5%-2%) and if rates rise, it was looking at a potentially large drop in the value of those investments.

“When the Fed raised the overnight borrowing rate from 3% to 5.5% in 1994,” notes Hui-Chien Chang, director of the portfolio management group, “the Barclays’ U.S. aggregate bond index had a dismal return of -2.94%.” That was not the kind of loss Google could accept.

Like any fixed-income security, MBS prices move inversely to interest rates, so rising rates depress prices. Agency mortgage-backeds have little perceived credit risk because they are issued by agencies of the U.S. government, but they have prepayment risk. The securities are backed by home mortgages and homeowners can pay off their mortgages at any time, so the duration is not fixed. Higher rates would discourage prepayments, lengthening the duration of the securities and making their price drop even more. Google needed a hedging strategy and an appropriate hedging instrument.

It found its hedge in the to-be-announced (TBA) market, which is liquid and transparent. In a TBA trade, a buyer and seller agree on general terms such as the type of security, the coupon, face value and price, but not the specific pool of mortgages. Trades settle only once a month. Until two days before settlement, sellers are free to choose which pool of mortgages to offer, so naturally they pick the worst-performing pool. This worst-to-deliver option is understood and priced into the trade.

TBA contracts work as hedges because if rates rise and mortgage prepayments slow, the value of the underlying MBS pool would drop but the payoff from shorting TBA contracts would generate positive returns to offset that drop, explains Aditya Agrawal, a senior portfolio analyst. Google also mitigates credit risk by negotiating collateral postings with its counterparties, he adds.

While this approach creates good economic hedges, they don’t qualify for hedge accounting treatment, Agrawal explains. As a result, the mark-to-market value change of the TBA hedges flows through the income statement without any offset from the changes in the underlying MBS portfolio, which are recorded on the balance sheet. Thus, a key constraint is “to manage the risk of the hedging program and control the accounting mark-to-market volatility associated with it,” he says.

Google also hedges by selling forward specified pools of mortgages that are revealed to the buyer before the sale. Because specified pools are usually of better quality than pools delivered to settle TBA contracts, they are priced at a premium over TBA prices, Chang says.

Read about the Microsoft project that won the Silver in the Financial Risk Management category here, the Ford Motor project that won the Bronze here, and the FLIR Systems project that won the Editors’ Choice Middle Market Excellence Award here.

Treasury & Risk

Treasury & Risk is an online publication and robust website designed to meet the information needs of finance, treasury, and risk management professionals. Our editorial content, delivered through multiple interactive channels, mixes strategic insights from thought leaders with in-depth analysis of best practices, original research projects, and case studies with corporate innovators.